How Corporate Law Inhibits Social Responsibility

After 23 years as a corporate securities attorney--advising large corporations on securities offerings and mergers and acquisitions--I left my position as partner at Skadden, Arps, Slate, Meagher & Flom because I was disturbed by the game. I realized that the many social ills created by corporations stem directly from corporate law. It dawned on me that the law, in its current form, actually inhibits executives and corporations from being socially responsible. So in June 2000 I quit my job and decided to devote the next phase of my life to making people aware of this problem. My goal is to build consensus to change the law so it encourages good corporate citizenship, rather than inhibiting it.

The provision in the law I am talking about is the one that says the purpose of the corporation is simply to make money for shareholders. Every jurisdiction where corporations operate has its own law of corporate governance. But remarkably, the corporate design contained in hundreds of corporate laws throughout the world is nearly identical. That design creates a governing body to manage the corporation--usually a board of directors--and dictates the duties of those directors. In short, the law creates corporate purpose. That purpose is to operate in the interests of shareholders. In Maine, where I live, this duty of directors is in Section 716 of the business corporation act, which reads:

...the directors and officers of a corporation shall exercise their powers and discharge their duties with a view to the interests of the corporation and of the shareholders....

Although the wording of this provision differs from jurisdiction to jurisdiction, its legal effect does not. This provision is the motive behind all corporate actions everywhere in the world. Distilled to its essence, it says that the people who run corporations have a legal duty to shareholders, and that duty is to make money. Failing this duty can leave directors and officers open to being sued by shareholders.

Section 716 dedicates the corporation to the pursuit of its own self-interest (and equates corporate self-interest with shareholder self-interest). No mention is made of responsibility to the public interest. Section 716 and its counterparts explain two things. First, they explain why corporations find social issues like human rights irrelevant--because they fall outside the corporation's legal mandate. Second, these provisions explain why executives behave differently than they might as individual citizens, because the law says their only obligation in business is to make money.

This design has the unfortunate side effect of largely eliminating personal responsibility. Because corporate law generally regulates corporations but not executives, it leads executives to become inattentive to justice. They demand their subordinates "make the numbers," and pay little attention to how they do so. Directors and officers know their jobs, salaries, bonuses, and stock options depend on delivering profits for shareholders.

Companies believe their duty to the public interest consists of complying with the law. Obeying the law is simply a cost. Since it interferes with making money, it must be minimized--using devices like lobbying, legal hairsplitting, and jurisdiction shopping. Directors and officers give little thought to the fact that these activities may damage the public interest.

Lower-level employees know their livelihoods depend upon satisfying superiors' demands to make money. They have no incentive to offer ideas that would advance the public interest unless they increase profits. Projects that would serve the public interest--but at a financial cost to the corporation--are considered naive.

Corporate law thus casts ethical and social concerns as irrelevant, or as stumbling blocks to the corporation's fundamental mandate. That's the effect the law has inside the corporation. Outside the corporation the effect is more devastating. It is the law that leads corporations to actively disregard harm to all interests other than those of shareholders. When toxic chemicals are spilled, forests destroyed, employees left in poverty, or communities devastated through plant shutdowns, corporations view these as unimportant side effects outside their area of concern. But when the company's stock price dips, that's a disaster. The reason is that, in our legal framework, a low stock price leaves a company vulnerable to takeover or means the CEO's job could be at risk.

In the end, the natural result is that corporate bottom line goes up, and the state of the public good goes down. This is called privatizing the gain and externalizing the cost.

This system design helps explain why the war against corporate abuse is being lost, despite decades of effort by thousands of organizations. Until now, tactics used to confront corporations have focused on where and how much companies should be allowed to damage the public interest, rather than eliminating the reason they do it. When public interest groups protest a new power plant, mercury poisoning, or a new big box store, the groups don't examine the corporations' motives. They only seek to limit where damage is created (not in our back yard) and how much damage is created (a little less, please).

But the where-and-how-much approach is reactive, not proactive. Even when corporations are defeated in particular battles, they go on the next day, in other ways and other places, to pursue their own private interests at the expense of the public.

I believe the battle against corporate abuse should be conducted in a more holistic way. We must inquire why corporations behave as they do, and look for a way to change these underlying motives. Once we have arrived at a viable systemic solution, we should then dictate the terms of engagement to corporations, not let them dictate terms to us.

We must remember that corporations were invented to serve mankind. Mankind was not invented to serve corporations. Corporations in many ways have the rights of citizens, and those rights should be balanced by obligations to the public.

Many activists cast the fundamental issue as one of "corporate greed," but that's off the mark. Corporations are incapable of a human emotion like greed. They are artificial beings created by law. The real question is why corporations behave as if they are greedy. The answer is the design of corporate law.

We can change that design. We can make corporations more responsible to the public good by amending the law that says the pursuit of profit takes precedence over the public interest. I believe this can best be achieved by changing corporate law to make directors personally responsible for harms done.

Let me give you a sense of how director responsibility works in the current system. Under federal securities laws, directors are held personally liable for false and misleading statements made in prospectuses used to sell securities. If a corporate prospectus contains a material falsehood and investors suffer damage as a result, investors can sue each director personally to recover the damage. Believe me, this provision grabs the attention of company directors. They spend hours reviewing drafts of a prospectus to ensure it complies with the law. Similarly, everyone who works on the prospectus knows that directors' personal wealth is at stake, so they too take great care with accuracy.

That's an example of how corporate behavior changes when directors are held personally responsible. Everyone in the corporation improves their game to meet the challenge. The law has what we call an in terrorem effect. Since the potential penalties are so severe, directors err on the side of caution. While this has not eliminated securities fraud, it has over the years reduced it to an infinitesimal percentage of the total capital raised.

I propose that corporate law be changed in a similar manner--to make individuals responsible for seeing that the pursuit of profit does not damage the public interest.

To pave the way for such a change, we must challenge the myth that making profits and protecting the public interest are mutually exclusive goals. The same was once said about profits and product quality, before Japanese manufacturers taught us otherwise. If we force companies to respect the public interest while they make money, business people will figure out how to do both.

The specific change I suggest is simple: add 26 words to corporate law and thus create what I call the "Code for Corporate Citizenship." In Maine, this would mean amending section 716 to add the following clause. Directors and officers would still have a duty to make money for shareholders,

... but not at the expense of the environment, human rights, the public safety, the communities in which the corporation operates or the dignity of its employees.

This simple amendment would effect a dramatic change in the underlying mechanism that drives corporate malfeasance. It would make individuals responsible for the damage companies cause to the public interest, and would be enforced much the same way as securities laws are now. Negligent failure to abide by the code would result in the corporation, its directors, and its officers being liable for the full amount of the damage they cause. In addition to civil liability, the attorney general would have the right to criminally prosecute intentional acts. Injunctive relief--which stops specific behaviors while the legal process proceeds--would also be available.

Compliance would be in the self-interest of both individuals and the company. No one wants to see personal assets subject to a lawsuit. Such a prospect would surely temper corporate managers' willingness to make money at the expense of the public interest. Similarly, investors tend to shy away from companies with contingent liabilities, so companies that severely or repeatedly violate the Code for Corporate Citizenship might see their stock price fall or their access to capital dry up.

Many would say such a code could never be enacted. But they're mistaken. I take heart from a 2000 Business Week/Harris Poll that asked Americans which of the following two propositions they support more strongly:

Corporations should have only one purpose--to make the most profit for their shareholders--and pursuit of that goal will be best for America in the long run.

--or--

Corporations should have more than one purpose. They also owe something to their workers and the communities in which they operate, and they should sometimes sacrifice some profit for the sake of making things better for their workers and communities.

An overwhelming 95 percent of Americans chose the second proposition. Clearly, this finding tells us that our fate is not sealed. When 95 percent of the public supports a proposition, enacting that proposition into law should not be impossible.

If business people resist the notion of legal change, we can remind them that corporations exist only because laws allow them to exist. Without these laws, owners would be fully responsible for debts incurred and damages caused by their businesses. Because the public creates the law, corporations owe their existence as much to the public as they do to shareholders. They should have obligations to both. It simply makes no sense that society's most powerful citizens have no concern for the public good.

It also makes no sense to endlessly chase after individual instances of corporate wrongdoing, when that wrongdoing is a natural result of the system design. Corporations abuse the public interest because the law tells them their only legal duty is to maximize profits for shareholders. Until we change the law of corporate governance, the problem of corporate abuse can never fully be solved.

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Robert C. Hinkley is a former corporate law partner in two of America’s largest law firms. He is also the originator of the Code for Corporate Citizenship, a 28 word modification in the corporate law to the duty of directors designed to improve corporate behavior. His recently released book: Time to Change Corporations: Closing the Citizenship Gap, can be purchased through Amazon.com where it is available both in paperback and for Kindle users as well.

Further

On this day 50 years ago, a platoon of U.S. soldiers entered the hamlet of My Lai in South Vietnam and, in hours, massacred 504 unarmed women, children and old men. Over 300 of the victims were younger than 12; the G.I.s also raped many of the women and burned all the homes. Today, with torturers and warmongers on the rise, the horrors of My Lai serve as a grim warning. In America's wars of choice, says one vet, we are all "one step away from My Lai."